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Basel Accord
The Great Depression and Regulation Q
The great depression circa 1929 was a watershed event for bank regulators because it showed, though not for the first time, how bank failures impacted society. A number of lessons came out of that event; the two most relevant to this conference were:
a) The critical role banking sector played in providing credit and access to capital at regional, national and global levels and its effect on economic growth.
b) The scale of human misery when the banking system failed and was no longer in a position to play that role.
The first attempt post depression to regulate banks came from the liability side. If there was a cap on the maximum rate a bank could pay to its depositors there was no longer an incentive for it to invest in increasingly risky assets. As long as an investment earned a reasonable spread over the cost of bank funds, a bank would stick to safer products and solutions. The culprit, in the thinking of that time, was rate-based competition for deposits - leading to increasingly risky behavior on part of banks. If you could control cost of deposits, you could control rate based competition and control risky behavior. The thinking stayed in vogue for more than 50 years after it first came into being as Regulation Q. A part of the Banking Act, 1933 that authorized the Federal Reserve to impose ceilings on the interest rates paid on time and savings deposits by member banks.
It was in the high inflation, high yield 80’s that this thinking was first challenged by emerging non-banking deposit products. Why earn a miserly two to four percent before taxes when your money market account could easily credit three to five times that amount. Challenged by non banking sector products that changed the dynamics of the deposit market, banks could no longer compete as long as they were held back by regulation Q. One side effect was non price competition for deposits including over supply of branches, automated teller machines, additional banking hours, free toasters, subsidized cash and exchange management services . The other more well known side effect was the growth and development of the offshore Euro Dollar market.
The time was now ripe for a more risk sensitive regulatory standard.
Basel I & Amendments to the Capital Accord
Basel I marked the shift toward linking capital with risk taking behavior when it introduced minimum capital requirements dependent on the risk profile of a bank’s credit portfolio. Introduced in 1988 as the Basel I capital accord or BIS 88, the regulatory framework took the first step towards supporting risk based pricing and creating a level playing field as far as capital was concerned in member countries.
Once the Capital Accord was rolled out, it became evident that credit was not the only source of risk on the balance sheet of a bank. Proprietary trading profits represented another source of volatility that banks could use to exploit risk-based gaps in the capital accord and sidestep the intent of the regulatory framework. Amendments to the capital accord followed in 1996 and became the basis for BIS 98. The revised standard now provided for calculation of market risk capital based on the profile of the trading book and a total capital adequacy ratio that factored both credit and price risk.
Basel II
The Basel I accord had a number of well-documented shortcomings. It ignored portfolio effects across a large well diversified banking book, it ignored relative credit worthiness between and across corporate and OECD borrowers, created a regulatory loop hole supporting 364 day revolving facilities with no capital charge, did not allow for netting or provide any incentives for credit risk mitigation .
These problems led to suggestions that the banking industry be allowed to develop their own internal model to calculate the minimum capital requirements. This would serve as the credit risk equivalent of the BIS 98 standard for market risk capital requirements and allow well-diversified banks to report numbers that were more reflective of the risks carried on their balance sheets.
The Basel II Accord addressed some of these concerns, introduced the concept of operational risk capital and provided capital requirements for new products that were previously not handled in the original capital accord. It took what is now regarded as the third and final step towards capital requirements that were reflective of credit, market and operational risk.
In recent years, banking supervisory bodies have all issued their own frame works defining how Basel II is to be implemented in their respected domains. For example, the state bank of Pakistan issued it Circular 8 (2006) titled “Minimum capital requirements for banks & DFIs – revised regulatory capital framework under Basel II” which details how Basel II accord is to be implemented at an institutional level in Pakistan.
The Basel II accord itself is composed of three pillars:
(1) Minimum capital requirements
(2) Supervisory review
(3) Market discipline
Minimum Capital Requirements
This is the first pillar deals with the credit, market and operational risk which the bank faces.
The credit risk component can be calculated using standardized approach, foundation internal ratings based approach or advanced internal ratings based approach. In the standardized approach the risk weight is applied on the basis of the rating of the counterparty and the maturity profile of the exposure. In the internal ratings based approaches the values of probability of default, loss given default, exposure at default and maturity are used in the computation for capital charge.
The market risk component relies on VaR approaches to compute the risk of the exposure. VaR shows that for a selected portfolio, how much you stand to lose, over a certain period and with a certain probability.
The operational risk component can be calculated using the basic indicator approach, standardized approach or advanced measurement approach. In the basic indicator approach, the average of the positive annual gross income figures is used to calculate the charge. In the standardized approach the banks’ activities are divided into eight business lines and the capital for operational risk for each of these lines is computed as a percentage of the bank's gross income from that particular line of business. In the advanced measurement approach the institutions employ their own empirical models to calculate the required capital for operational risk.
Supervisory Review
This is the second pillar and it deals with the regulatory response to the first pillar and provides a frame work for dealing with residual risks such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk.
Market Discipline
This is the third pillar and it details the obligations of the bank to disclose information to all stakeholders. The clients and shareholders should have sufficient understanding to comprehend how the bank manages its risks. The purpose is to allow more transparency and let the market have a better idea of the banks risk positions so that they can deal with the bank in a better way.
Thoughts going forward
In a world where capital is neither free nor abundant, the new paradigm is risk based pricing. For some of us here, this is a little outside of our comfort zone. With the implementation of Basel II and the removal of traditional barriers to doing business across geographic boundaries, we as bankers need to think more carefully about the capital impact of our choices. This cannot be done till we include and accept risk capital based resource allocation in our mindset, our pricing, our decision-making and our regulatory reporting processes. This will introduce a significant new cost component in our pricing - both in terms of contributed capital costs as well as in terms of investments in technology, infrastructure, process improvement and change management. If we haven’t thought about this so far, willingly, the Basel II implementation deadlines will make us do so in the next few months. Those of us who do well in accepting and implementing these new frameworks will succeed as institutions and bankers. Those of us who don’t will face many difficult challenges in the years to come.
References:
Banking Act of 1933. Regulation Q or Reg Q for short was extended to all FDIC (Federal Deposit Insurance Corporation) insurance banks by 1935.
Contemporary Financial Intermediation, Greenbaum, Thakor, Dryden Press, 1995.
Risk Management, Michel Crouhy et.all, McGraw Hill, 2001.
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